Inflation Problem Set
Terms
Definition
Inflation
A general rise in prices
Hyperinflation
Inflation that exceeds 10% annually
Purchasing Power
Refers to the ability of currency to purchase goods and services
Deflation
A general fall in prices; often occurs during recession; sounds good, but
can apply to incomes
Stagflation
A combination of falling real GDP and rising price levels- typically caused
by cost-push inflation; occurred during the 1970s with OPEC Oil Embargo
The process of bringing down the rate of inflation
Disinflation
Inflation Rate
Real Wage
Real Income
Shoe Leather Costs
Menu Costs
A measurement of how quickly prices are rising; can be measured using
price indexes such as Consumer Price Index, Producer Price Index, and the
GDP Deflator
Wage rate divided by price level: For this and Real Wage, think about our
“Bag of Mystery.” Though inflation led “income” (beans) to increase, your
purchasing power really did not change
Income divided by price level
Costs incurred when people try to prevent holding money; Ex- During
periods of hyperinflation in some countries, people would be paid multiple
times a day; They would get off work, run to make purchases, then come
back to work.
Costs faced by producers when they must change listed prices due to
inflation (EX: print new menus, change prices on shelves….etc.)
Unit of Account Costs
Cost that results when inflation makes a currency a less reliable unit for
measuring value
Real Interest Rate
Nominal interest rate minus rate of inflation; Example: If you are a saver,
and the nominal interest rate is 6%, but the rate of inflation is 5%, then
the real interest rate is only 1%
A measure of overall level of prices in an economy
Aggregate Price Level (We
will mainly call it Price
Level)
Price Index
Consumer Price Index (CPI)
A measure of overall price level tied to a base year; enables the
measurement of inflation
An index that measures the price of a “market basket” of goods and
GDP Deflator
services typically purchased by the average urban consumer in a month;
used to measure inflation.
Used to measure inflation; A ratio of nominal GDP to real GDP in that year
(times 100): (Nominal GDP/Real GDP)X100
Producer Price Index (PPI)
An index that measures the “market basket” of typical goods purchased
by producers including raw materials and other factors of production
Quantity Theory of Money
MV = PY
General idea that the amount of money in the economy can impact the
overall rate of inflation
Demand Pull Inflation
(Define it and draw it.)
Inflation that is caused by an overall increase in demand for products;
Typically occurs during expansion of the business cycle.
Cost-Push Inflation
(Define it and draw it.)
Inflation that is caused by an overall decrease in supply; This is usually
caused by substantially rising producer costs.
CONCEPT QUESTION
How does inflation relate to
purchasing power?
ANSWER
An increase in inflation leads to a fall in purchasing power, meaning each
dollar will buy less than it did before
How does hyperinflation
Hyperinflation affects the monetary flow. People begin to lose faith in the
relate to the circular flow of dollar as a medium of exchange. People will begin rushing to use their
the economy?
currency and not hold it. Also, due to the uncertainty of what prices will
be tomorrow, people will only purchase necessities. This will begin to slow
the circular flow and the overall economy will begin to shut down.
Which type of inflation is
Quantity Theory of Money is the main cause of hyperinflation. This occurs
the primary cause of
when the government prints too much money at one time (often to pay
hyperinflation?
debts). (Post World War I Germany, Bolivia in the 1980s)
Discuss the actions of
individuals and banks
during a period of
hyperinflation. What do
they do to best protect
themselves?
What does each
component of the following
equation stand for?
People begin to lose faith in the dollar as a medium of exchange. People
will begin rushing to use their currency and not hold it. Also, due to the
uncertainty of what prices will be tomorrow, people will only purchase
necessities. Banks will refuse to lend unless the interest rate is adjustable
so that they can protect themselves from inflation.
M = Money Supply
V = Velocity of Money (how quickly money is spent)
P = Price Level
Y = Real Output
MxV=PxY
Based on the equation
above, if more money was
put into the money supply,
and the velocity of money
stays constant, what will
happen to price level and
GDP?
PY should rise, however, this rise will be driven by a rise in P, not a rise in Y
Module 14 – Check Your Understanding p.140
#1
Shoe-leather costs will be lower because people can use electronic means
24-7 to make necessary transactions.
#2
If inflation stops, then the 0% interest rate will be less than the anticipated
2-3% inflation rate. The real interest rate will be higher than anticipated,
meaning lenders will gain and borrowers will be paying higher “real”
interest rates, though the nominal interest rate will be the same. GainLender / Lose - Borrower
Multiple-Choice Questions p.140
#
1
2
3
4
5
Answer Explanation
e
I – definition; II looks like it could be false, but levels of prices may not matter because
nominal wages /incomes may keep up to make purchasing power the same; III- the fact
that the % change in price matters is why we measure the rate of inflation- key issue is
are INCOMES rising at the same % as price level
C
Real wage is wage rate divided by the price level; Nominal wage is rising at the same
rate as price level, therefore REAL WAGE is the same – in other words, purchasing power
has not changed.
B
Definition of shoe-leather costs
D
Inflation makes a currency less reliable in terms of measuring the value of something
c
Definition of menu costs
FRQ #2
a. Real Interest Rate 0% (Nominal Interest Rate – Rate of Inflation)
b. You paid no real interest for the couch. You borrowed enough money to buy a couch, and after
inflation, you paid exactly what it would have cost to buy the couch.
c. The lender lost. They had expected to make a 5% gain, but due to the unanticipated inflation,
they received a real interest rate of 0%.
Module 15- Check Your Understanding p.147
#1
#2
#3
Pre-Frost
Oranges (100 X 0.20) = $20
Grapefruit (50 X 0.60)= $30
Lemons (200 X 0.25)= $50
Total Basket Cost: $100
Post-Frost
Oranges (100X.40)=$40
Grapefruit (50 X 1.00)=$50
Lemons (200 X 0.45)=$90
Total Basket Cost: $180
This market basket has experienced an 80% increase in price due to the frost. In
the book example, the price increase was 84.7%. The difference is due to the makeup of the basket. There are more lemons in the second basket. They increased in
price by 80%. There were fewer oranges in the second basked. They increase in
price by 100%. Hence, we see that the composition of a market basket matters. If
you put more of an item that increase in price by a greater rate, then the CPI will
rise more quickly. If you put less of that item, then the CPI will not matter as much.
a. A 10-year old market basket will not contain as many cars as people
actually purchase. Car prices are rising as well. Therefore, the 10-year old
market basket will UNDERSTATE the rise in prices for consumers because it
won’t include enough cars.
b. A 10-year old market basket will not include broadband at all. There would
be no way to reflect the gradual fall in prices of the internet access.
Therefore, the rise in prices would be overstated.
[(New-Old)/Old] X 100
207.3 – 201.6 = 0.028 X100 = 2.8%
201.6